CHAPTER 10
MAKING CAPITAL INVESTMENT DECISIONS
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
CHAPTER OUTLINE
• Project Cash Flows: A First Look
• Incremental Cash Flows
• Pro Forma Financial Statements and
Project Cash Flows
• More about Project Cash Flow
10-2
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
RELEVANT CASH FLOWS
• The cash flows that should be included
in a capital budgeting analysis are
those that will only occur (or not
occur) if the project is accepted
• These cash flows are called
incremental cash flows
• The stand-alone principle allows us to
analyze each project in isolation from
the firm simply by focusing on
incremental cash flows
10-3
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
ASKING THE RIGHT QUESTION
• You should always ask yourself “Will this
cash flow occur ONLY if we accept the
project?”
If the answer is “yes,” it should be included in the
analysis because it is incremental
If the answer is “no,” it should not be included in
the analysis because it will occur anyway
If the answer is “part of it,” then we should
include the part that occurs because of the project
10-4
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
COMMON TYPES OF CASH FLOWS
• Sunk costs – costs that have accrued in the past
• Opportunity costs – costs of lost options
• Side effects
Positive side effects – benefits to other projects
Negative side effects – costs to other projects
• Changes in net working capital
• Financing costs
• Taxes
10-5
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
PRO FORMA STATEMENTS AND
CASH FLOW
• Capital budgeting relies heavily on pro forma
accounting statements, particularly income
statements
• Computing cash flows – refresher
Operating Cash Flow (OCF) =
EBIT + depreciation – taxes
OCF = Net income + depreciation
(when there is no interest expense)
Cash Flow From Assets (CFFA) =
OCF – net capital spending (NCS) – changes
in NWC
10-7
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
EXAMPLE 1 :
• We estimate that we can sell 50,000 cans of
shark attractant per year at a price of $4 per
can. It costs us about $2.50 per can to make
the attractant, and a new product such as
this one typically has only a three-year life.
We require a 20 percent return on new
products. Fixed costs for the project will run
The cost of the Project
$12,000 per year. Further, we will need to
because this is the invest a total of $90,000 in manufacturing
assets we sill use.
equipment which we will assume that will be
100 percent depreciated over the three-year
life of the project Furthermore, the
equipment will be essentially worthless on a
market value at the end of its life. Finally,
the project will require an initial $20,000
investment in net working capital, and the
tax rate is 34 percent. Should we accept this
project?
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 10-8
TABLE 10.1 PRO FORMA
INCOME STATEMENT
Estimate the Net Income
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) Non-Cash Expense 30,000
EBIT Earning Befor Interest and Tax $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780
+ Depreciation 30,000
OCF 51,780 10-9
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TABLE 10.5 PROJECTED TOTAL
CASH FLOWS
Capital Budgeting Analysis
Year Duration of the Project
Cost 0 1 2 3
OCF $51,780 $51,780 $51,780
Change -$20,000 20,000
Future Revenue
in NWC Salvage value is the residual
value after tax
NCS -$90,000
Cost of the Project
CFFA -$110,00 $51,780 $51,780 $71,780
10-10
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MAKING THE DECISION
• Now that we have the cash flows, we
can apply the techniques that we
learned in Chapter 9
• Enter the cash flows into the
calculator and compute NPV and IRR
CF0 = -110,000; C01 = 51,780; F01 = 2;
C02 = 71,780; F02 = 1
NPV; I = 20; CPT NPV = 10,648
CPT IRR = 25.8%
• Should we accept or reject the
project?
10-11
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DEPRECIATION
• The depreciation expense used for capital
budgeting should be the depreciation
schedule required by the IRS for tax
purposes
• Depreciation itself is a non-cash expense;
consequently, it is only relevant because it
affects taxes
• Depreciation tax shield = D × T
D = depreciation expense
T = marginal tax rate
10-12
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COMPUTING DEPRECIATION
• Straight-line depreciation
D = (Initial cost – salvage) / number of
years
Very few assets are depreciated straight-
line for tax purposes
• MACRS
Need to know which asset class is
appropriate for tax purposes
Multiply percentage given in table by the
initial cost
Depreciate to zero
Mid-year convention
10-13
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AFTER-TAX SALVAGE
• If the salvage value is different from
the book value of the asset, then
there is a tax effect
• Book value =
initial cost – accumulated
depreciation
• After-tax salvage =
salvage – T*(salvage – book
value) 10-14
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EXAMPLE: DEPRECIATION AND
AFTER-TAX SALVAGE
Cost
• You purchase equipment for $100,000, and it
costs $10,000 to have it delivered and
installed.
• Based on past information, you believe that
you can sell the equipment for $17,000 when
you are done with it in 6 years.
• The company’s marginal tax rate is 40%.
• What is the depreciation expense each year
and the after-tax salvage in year 6 for each
of the following situations?
10-15
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EXAMPLE: STRAIGHT-LINE
• Suppose the appropriate depreciation
schedule is straight-line
D = (110,000 – 17,000) / 6 = 15,500 every
year for 6 years
BV in year 6 = 110,000 – 6(15,500) =
17,000
After-tax salvage =
17,000 - .4(17,000 – 17,000) =
17,000
10-16
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That’s meen you have 4 periods
EXAMPLE: THREE-YEAR MACRS
Year MACRS D
percent % x Cost BV in year 6 =
110,000 – 36,663 –
1 .3333 .3333(110,000)
48,895 – 16,291 –
= 36,663 Dep Expense
8,151 = 0
2 .4445 .4445(110,000)
= 48,895
After-tax salvage
3 .1481 .1481(110,000) = 17,000
= 16,291 - .4(17,000 – 0) =
4 .0741 .0741(110,000) $10,200
= 8,151
Fully depreciated
10-17
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EXAMPLE: SEVEN-YEAR MACRS
Year MACRS D BV in year 6 =
Percent % x Cost
110,000 – 15,719 –
1 .1429 .1429(110,000) = 26,939 – 19,239 –
15,719
13,739 – 9,823 –
2 .2449 .2449(110,000) =
26,939 9,812 = 14,729
3 .1749 .1749(110,000) =
19,239 After-tax salvage
4 .1249 .1249(110,000) = = 17,000
13,739 – .4(17,000 –
5 .0893 .0893(110,000) = 9,823 14,729) =
16,091.60
6 .0892 .0892(110,000) = 9,812
The machine has sold at the end of yaer 6 because of the project will end at this yaer.
10-18
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EXAMPLE: COST CUTTING
• Your company is considering a new computer system
that will initially cost $1 million.
Cost of the project
• It will save $300,000 per year in inventory and
receivables management costs.
Revenue - Costs
• The system is expected to last for five years and will
be depreciated using straight line method.
• The system is expected to have a salvage value of
$50,000 at the end of year 5.
Market Value
• There is no impact on net working capital. The
marginal tax rate is 40%. The required return is 8%.
10-19
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COMPREHENSIVE PROBLEM
• A $1,000,000 investment is
depreciated using a seven-year
MACRS class life.
• It requires $150,000 in additional
inventory and will increase accounts
payable by $50,000.
• It will generate $400,000 in revenue
and $150,000 in cash expenses
annually, and the tax rate is 40%.
• What is the incremental cash flow in
years 0, Copyright
1, 7, and
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by McGraw-Hill 10-21
